A little learning is a dangerous thing;
drink deep, or taste not the Pierian spring:
there shallow draughts intoxicate the brain,
and drinking largely sobers us again.
Alexander Pope (1688-1774)
An essay on Criticism

Today’s lengthy story in the Wall Street Journal about BP’s missteps leading to the blowout in the Gulf and subsequent chain of disasters now consuming both the ecology and the news serves as a reminder of how fragile markets can be and why regulation is indispensable to our safety. Despite the best intentions in the world, things go wrong. We are all subject to exactly the same kinds of pressures BP faced–time constraints, escalating costs, mistakes in judgment, and the uncertainty of the unknown. As one of the people I admired most in business, former Wachovia CEO John Medlin, once put it to me, you never see the lightning that strikes you. So you can never entirely predict what can go wrong.

Without some kind of third party arbiter or enforcer, competitive pressures inevitably lead to a race to the bottom. The time delays and expense of extra precautions, longer testing, better backup plans and crisis scenario planning place pressure on management. Managers almost inevitably begin to skimp on safeguards and, without baseline rules and supervision, this leads to excessive risk taking. The problem is not unique to BP; on the contrary, we have seen the terrible results of such unrestrained competition in many areas. Mining and financial are the most obvious recent examples. The short-termism of the market is inadequate by itself to ensure that discipline and precaution is spread adequately throughout the industry.

So regulation is one of the ways in which a “neutral” framework can be imposed. In the case of oil drilling, the Minerals Management Service (MMS) was meant to be that arbiter but, as we have seen from the recent report of the inspector general for the Department of the Interior, that agency appears to have failed miserably in its job. To be fair, however, BP even deviated from the directions of the MMS.

Bad things happen. Sometimes this is used as an excuse. Many defenders of practices on Wall Street tried to hide behind the so-called Black Swan, arguing that the financial disaster was simply unforeseeable. Not only is this factually untrue–there were plenty of warnings in the run up to the crisis that were bluntly ignored–but it is also precisely the reason for precautions driven by interests greater than those of corporate executives.

There has been much finger pointing over the drama in the Gulf. Of course there seem to have been numerous entities at fault and BP is probably not alone in holding the blame. Holding the responsible parties accountable is critically important as a means of preventing or reducing the likelihood of future disasters. But the blame game is usually unproductive for developing the right response and a model of safety for the future. So much sober assessment and careful policy development will need to take place. But to assume that a safe result can be achieved without a strong regulatory framework is unrealistic.

Believe it or not and despite everything that has happened, there are still some leading bankers who try to argue that government should get out of the business of financial regulation. Leaving aside arguments about the right level of regulation and whether it is properly designed for effectiveness, public safety alone demands much more sophisticated, strong and thoughtful regulation than we have in many areas right now.

If we do not take the development of such regulation seriously, the fickle finger of fate will surely become a dirty digit of destiny.

A major justification for regulation is that markets are not always efficient in pricing the full cost or value of a transaction. When this happens, regulation is needed to address what are called “externalities.” This is not a difficult concept but sometimes non-economists find it perplexing. Here’s an easy way to understand it in pure economic terms: dead miners, dead oil rig workers and dead marshes that were once lush and green are “externalities.” So are lots of the folk who lost their jobs recently.

Yesterday Mark Gongloff of the Wall Street Journal ran a story describing how the looming passage of financial reform legislation will almost certainly lead to substantial downgrades in the credit ratings, and corresponding increase in costs of borrowing to, the very large financial institutions such as Citigroup and Bank of America. Others implicated, though to a lesser extent, would be Wells Fargo and Goldman Sachs Group. Though its exact implications are contested, Gongloff’s report rightly highlights the fact that financial reform will likely cost the (very large) banks real money.

So will financial reform hurt the economy? That’s the prevailing claim of financial industry players and their lobbyists — and on their terms they are right. But a one-sided focus on the costs to the financial sector overlooks both the extent to which its rich bottom line is taxpayer subsidized and the great cost of doing nothing.

It’s clear that reform comes with a price tag. Increased market transparency would require many derivatives to be traded on exchanges and greater disclosures in consumer financial products. Intensified capital requirements and supervision would reduce the amount of leverage available to financial firms. More rigorous underwriting standards would make it harder for banks to lend. Stricter divisions between deposit taking and proprietary trading (the “Volcker Rule”) would reduce revenue opportunities. All of these measures, and probably many others, would dampen the growth of the financial services sector, reduce its profitability, and perhaps even slow down its capacity to increase credit and introduce new products.

This is not a bad result. First, it cannot be assumed that continued growth from the status quo is a net benefit. In the past 40 years the financial sector’s share of GDP more than doubled. While we debate whether and why this rate of financial sector growth is desirable, we can surely agree on one thing: Americans became overextended as total consumer credit and personal debt service capacity grew at alarming rates between 1995 and 2008. This was unsustainable.

The fact that financial players for whom the party never really ended would like to keep it going is not a justification for backing off reform. Providing a mechanism to enforce greater transparency in disclosures and prevent abusive credit practices will help avoid a situation in which consumers cannot understand or afford the credit enticements they are offered. Likewise, forcing greater transparency in the derivatives markets will promote competition and reduce margins earned only from privileged access to information.

Second, focusing solely on the cost to the financial sector overlooks the alternative costs to the economy in general if we don’t reform. The fact is that financial services are highly subsidized. Subsidies come from a variety of sources, including deposit insurance, Federal Reserve credit and liquidity, regulatory protections, TARP funds and more. The benefits to financial institutions flowing from the TARP funds alone have been estimated by the Center for Economic Policy and Research to run at $34 billion a year. Some of the bigger institutions have repaid loans, and the Treasury stands to make a profit on some of its capital investments. This does not alter the reality of the subsidy, nor does it offset the massive costs of the stimulus and the looming deficit, triggered in large part by the financial crisis. As described above, ratings agencies have indicated that reductions to these government subsidies will lead to significant credit downgrades and raise the cost of borrowing, but the alternative is government-subsidized financial services.

And, third, in an industry in which real costs of doing business are externalized way beyond the executives and shareholders, the benefits that the industry itself enjoys from maintaining the status quo are massively outweighed by the costs to which the public (meaning taxpayers) are exposed. The social and economic costs might well be far greater, particularly if financial behemoths are allowed to continue unchecked. A recent high-level study at the Bank of England strongly suggests the very large global financial institutions, including American ones, are actually imposing a substantial drag on economic recovery, perhaps to the tune of $60 billion per institution.

In his recent letter to shareholders, JP Morgan Chase & Co’s CEO Jamie Dimon, suggested that only banks of Morgan’s size can provide the services and efficiency necessary to America’s large corporations and they will simply go elsewhere if they can’t get those services in America. This argument evades reforms that are also underway abroad. In any event, large financial institutions, including Dimon’s, regularly syndicate their services with other banks. Few large companies entrust their financial services to only one bank. And there is simply no evidence to suggest that such large banks are more efficient than their smaller counterparts; on the contrary, the weight of accumulating evidence demonstrates they are significantly less efficient. (More on bank efficiency to come in a later post.)

Giving regulators the power to restrict and even break up these large institutions when they become systemic risks to the economy will help prevent the prevalence of financial institutions that are too big to fail yet also too big to manage, regulate or afford.

Done right, the real costs of reform will rightly be borne by industry players, where in a capitalist economy they belong. Decrying the “costs” of reform is the canard of industry free loaders. For the economy and the public at large, the real costs of not engaging in strong reform will be far greater.

Congress has made much more progress on financial reform than cynics might have thought. The House and Senate bills have now been passed with strong majorities and will now be reconciled in what will surely be a bruising conference committee. The conference will proceed from June 15 and Congressional leaders hope to present the final legislation to the President for his signature by July 4.

What we will get, naysayers notwithstanding, is a lot better than nothing.

There will be a properly resourced systemic risk council, headed either by the Fed or the Treasury, depending on whether the House or Senate version is adopted. This is vitally necessary, given the interconnected nature of modern finance and the lessons we all learned from Lehman.

Some means of forcing the industry to pay for the costs of failure will be adopted, either in the form of an advance tax (a bad idea) or subsequent ability to collect the costs (but will this really be enforceable?).

Regulation of derivatives activity, at least through greater transparency and exchange, though whether the more radical Senate version that would force banks to push out their derivatives activities (a very bad idea) will be adopted is uncertain. The industry and even the White House will lobby very fiercely against this.

Realistic consumer protection, either in the form of an independent bureau within the Fed (a curious idea) or a completely independent agency (which makes the most sense but which is driving the industry crazy). There will also be some ability on the part of state attorneys general to provide more local consumer protection enforcement.

Some form of the “Volcker Rule,” either banning banks from proprietary trading or authorizing regulators to break up big banks under distressed circumstances.

Greater focus on executive compensation to improve the links between risk and reward and prevent brokers and executives from profiting from activities that generate huge short-term fees but introduce massive long-term dangers to the institutions involved or the system as a whole.

Regulatory responsibility to develop better prudential standards, or at least the power to impose them, on financial activities. For example, no more no-doc (we won’t check), ninja (no income, no job) or liar (say anything in the application you want) loans. Better capital standards, and much more in the details.

New, though still to be worked out, powers to place systemically important financial players beyond the banking industry (e.g., Lehman and AIG) into fast track receivership before they fail completely and take everyone else down with them.

These reforms will together represent a major modernization of financial regulation. They will impose far-reaching changes on the business. Unfortunately Congress still ended up punting on major issues, and until these are addressed we won’t have fixed everything by any means and will continue to risk many more crises–perhaps one even bigger the Crash of 2008.

We have not taken on the behemoths. There is increasing evidence to suggest that the ultra large financial institutions are not only inefficient and dangerously risky; a recent Bank of England study suggests they are actually a drag on national and global economic recovery. The House Bill contains powers for the regulators to break up large financial institutions when this is necessary for financial stability, but efforts in the Senate to impose even mild caps on bank size were defeated. Unlike actions by the European Commission and British government to downsize financial institutions on life support (ING, Lloyds, and others), US regulators have not taken strong action to dismantle our own juggernauts in the midst of crisis. This raises the question whether the regulators will really be able to use the provisions in the House bill, even if they survive conference.

Regulatory restructuring has barely begun. We desperately need a strong lead bank regulator to address the complexities of modern, large-scale bank regulation. The Fed has gained greater powers but not enough for this purpose. The OTS will be merged into the OCC, but the FDIC will keep its supervisory powers in addition to its extensive new resolution powers. Insurance regulation has not been standardized, let alone consolidated. (We should not forget that AIG is primarily an insurance company.) Bank regulators don’t even have supervisory power over important financial institutions that form a critical part of the financial fabric. Unless and until we address this mish-mash of crazy quilt regulation we will never establish comprehensive financial regulation. Regulatory arbitrage will continue, and this means that financial innovation will drive new and unsupervised risks to which we are all ultimately exposed.

Industry restructuring–perhaps like reintroducing Glass-Steagall–is advocated by some as an essential element of proper reform. This is a much more debatable issue, but we haven’t even managed to dispose of the thrift charter yet. While the OTS will almost certainly meet its demise as a separate agency, the House bill would maintain the thrift charter itself. The ability of thrifts, industrial loan companies, credit unions and other financial organizations to evade proper regulation has proven just as important in contributing to recent crises as the ability of banks and investment companies to affiliate by reason of the 1999 repeal of Glass-Steagall.

Fannie Mae and Freddy Mac will only be addressed after the new bill is enacted. While I am not among those who believe that easy access by poor people to mortgages created the crisis, there is no question that then housing agencies that facilitated the irresponsible orgy of securitization that drove easy mortgage lending and greatly inflated the asset bubble leading that eventually burst in 2008 badly need reform. These housing enterprises have a long history of dysfunction, even corruption, and cannot heal themselves, no matter ho earnestly their current leadership tries. We have to reset our public policy priorities and restructure or recreate these agencies accordingly.

The global dimension of financial reform remains at the level of talk. None of the financial institutions that matter confine themselves to US operations, and our own economy is heavily dependent on foreign financial activity. Indeed, three of the top ten bank holding companies in America are foreign-owned, and many, many more large foreign institutions operate in the US. There is global consensus on some of the prudential standards but we are a long way from reaching anything like consensus on overall regulatory governance. Until we do the prospect of uncoordination and international regulatory arbitrage remains as real as ever.

Honesty remains a stranger to much financial reporting. Accounting, tax and reporting tricks are prevalent, and widely different standards apply from country to country. Until we can secure greater transparency and consistency in accounting, taxation and reporting, we cannot know what is really going on and inconsistencies will encourage widespread arbitrage.

So there is much left to be done. We have a 21st Century global financial system and a fragmented, 20th Century regulatory framework. The new reforms will help some, and at least we have greater public awareness. But we still have a leaky regulatory colander. Finding new ways to regulate the dynamic, complex global financial system will become critical.

The much-publicized report by the Department of the Interior’s Inspector General on conduct by employees of the Minerals Management Service (MMS) provides a lurid example of a fundamental problem underlying US economic regulation: regulatory capture. As highlighted by many examples over the years, US regulatory agencies are particularly susceptible to “capture” by the very industries they are meant to be regulation. Those very familiar with specific areas of regulation will be aware of a pervasive and multi-level industry influence over the ways in which those industries are regulated,

In other words, the industry, through its direct and indirect influence on the regulators, is able to shape the standards the regulators apply and the way in which these standards are enforced. The techniques range widely, from outright bribery (as in the MMS case) to engaging sympathetic congressmen to lean on regulators (themselves dependent on financial support from the industry) to hiring the best regulators with offers of huge salaries (these former regulators then being able to “decode” the industry interaction with the regulators or use their residual influence at the regulatory agency to secure favorable terms for their new employers). Regulated industries also tend to exert considerable influence over the ongoing staffing of agencies. It is commonplace for agency staff, particularly at the higher levels, to be drawn directly from the industry itself, before they return to the industry to make even more money. This creates a classic “revolving door” situation that can only make the problem more insidious.

I cannot think of a single area of economic regulation that has been or is currently free of some form of regulatory capture.

Not all industry influence is inappropriate: after all, industries exist to make money and, if lawful, their prosperity benefits us all. They should be able to influence the development and application of sensible and appropriate regulations. And industries are entitled to proper regulatory expertise and intelligent, well-versed regulators. But backdoor influence that leads to the kind of capture to which I am referring undermines the whole point of regulation. To use the old metaphor, it leads to the fox guarding the henhouse.

So why is the problem so prevalent in America?

First, we should note that the problem is not exclusive to America by any means. It has grown dramatically in recent years, for example, in Europe–perhaps partly under the cultural influence of American economic participation in the European Union, but also as an inevitable result of the matters at stake. Secondly, the proponents of what is called public choice theory, led by economist George Stiglitz, would argue that the problem is inherent in regulation itself, because regulation is more often than not the product of industry choices and not some kind of general public interest. Realtors, lawyers and hairdressers, for example, might want licensing because it protects them from competition, not because it maintains public standards. In other words, under public choice theory industry is protected, not constrained by regulation. But I do not subscribe entirely to public choice theory because there is a lot of evidence that supports the view that much, if not all, regulation is initially set up to promote public interests, such as safety, competitive markets, and so on. I would of course include realtors, lawyers and barbers in this category. And I do believe that many–perhaps most–people are or can be inspired to “do the right thing” for everyone and not just themselves.

In my view there are many reasons why we have regulatory capture. Fixing the problem is also very complicated, particularly in the American culture. We simply don’t take regulation seriously enough as a society. Indeed, because it seems counter to the “free market” philosophy we all share, becoming a regulator is sometimes portrayed as a sign of failure. “Real men” would be out there actually making the economy work.

To be sure, there are many public-minded Americans–perhaps even proportionately more than in most other countries–but public service is seldom a chosen career path, at least for very long. And for good reason. We don’t teach its virtues and we don’t reward public service adequately. Where are the professors of regulation in the US? We don’t give knighthoods to regulators. They don’t get paid much in other countries, such as the United Kingdom, either but at least they are considered important. But what do we do? We pull them up in front of Congress and beat up on them, so they go get highly paid jobs in the private sector.

We have to figure out ways to modernize regulation from the ground up. This will involve better understanding of the regulatory function through teaching at our higher institutions of learning. It will involve the courage to restructure agencies when changed economic conditions so demand (a courage that has failed Congress in the current financial reforms). It will involve developing incentives (not always financial) for the “best and brightest” and highly skilled young people to go into agencies to help develop the firepower required for effective regulation of powerful industries–and earn those industries’ respect. Modernization would also develop better firewalls between regulators and the regulated. And we need to figure out how to extend a proper social respect for the profession of regulation. Such respect has existed in America from time to time–for the SEC for example, and until recently for the Fed, which were once considered to be elite agencies where graduates clamored to find positions.

Each of these tasks is much easier to state than meet. Some branches of government, such as the military JAG Corps and Naval SFTI Program (TOPGUN) have managed to establish programs of elites who are as highly skilled and motivated as one could find anywhere in the world, yet are compensated on much lower salaries than might be earned in the private sector. In a column last year a former colleague and I toyed with the idea of similar elite corps within the financial agencies, and more recently another commentator has drawn on the example of the Foreign Service for similar suggestions. For years a few, sparsely read and perhaps too ideologically-driven publications have striven sincerely to promote serious thinking about regulation. More recently, however, important and constructive new books, centers and projects are starting to appear and these publications, their adoption in universities and the study promoted by such projects will help to provide a more sophisticated and stable base upon which we can build a regulatory system that meets the challenges of our modern economy.

Until we as a society come to respect the vital role of regulation and start taking it seriously, we will continue to have a situation in which the regulatory systems we create end up serving the industries they are meant to supervise rather then the public they should be protecting.

“Regulation” is now part of our common parlance. One is almost as likely to find animated controversy in popular media on regulation of the environment, health care, oil and gas drilling, mining and, of course, banking, as one might find debates on “freedom of expression,” “privacy,” and “separation of church and state.” Yet, like these other concepts, “regulation” is a rather complicated concept with exceptional technical detail in its application. So the term is worth a few moments’ reflection.

An ancient word deriving from Latin, “regulation” means a lot of things, from controlling or governing and activity through oversight or supervision to creating a framework for such activity through rules and orders (“regulations”). There is a whole range of regulatory structures and techniques. What is important is that regulation is not the activity itself. To regulate trade, for example, is not to trade but to create the conditions under which trade takes place.

Why is this important? It is not just an academic point. Take the stock market. Registering and trading stocks are market activities, but the market does not exist by itself as some kind of natural phenomenon; it has to be created and maintained, and this is where regulation comes in. So regulation is as necessary to markets as market conduct itself. Sometimes this is forgotten, particularly in debates about the role of government in regulation. At one end of the spectrum extreme libertarians take the position that markets are or should be self-regulating and that all forms of government intrusion are illegitimate. At the other end, extreme socialists or communitarians believe that “market” activity is really a usurpation of the functions of the collective–whether this be a community or state.

The genius of America, historically, has been to create a balance between the enormous efficiencies of relatively free market behavior and the need to create and maintain such markets in the first place. This is why antitrust law, which seeks to preserve competition in markets, is so important: without competition markets can naturally degenerate toward the winner-take-all situation of a monopoly. Without other forms of government regulation, markets also tend to “externalize” the costs of market activity as a result of “inefficiencies,” such as insufficient or one-sided information, or “market power” (where one party enjoys disproportionate bargaining power because of size or some other advantage). This externalization leads us to pay more for products than would be the case in a genuinely competitive market, or to pay for the damage inflicted by risks that a market participant–say a bank or hedge fund–generates because the market participant did not properly manage those risks and pulled other participants down with it when it failed. Such bailouts are always resented because innocent parties have to bear the costs of damage inflicted by irresponsible actors.

“Deregulation” is a related term that came into vogue in the United States in the early 1970s when heavy-handed regulation of the airline, telecommunications and energy industries was seen to be counterproductive. Over the past 40 years we have witnessed wide scale deregulation across numerous industries. Although the deregulatory movement had begun earlier under President Carter, Ronald Reagan, in a famous turn of phrase in his First Inaugural Address (1981)–“government is not the solution to our problem; government is the problem”–symbolically and ideologically set the stage for an era of “deregulation” that lasted until 2008 when the financial crisis cast great doubt on the merits of relying too heavily on “market discipline” as a form of self-regulation. Yet even in this period of deregulation, regulation did not disappear, nor could it. Adam Smith is often taken out of context for the view that markets can be self or “naturally” regulated (Adam Smith, Inquiry into the Wealth of Nations II.iv.i.9), yet Adam Smith himself was at pains to delineate an important role for governments in creating and sustaining such markets in the first place, and he also presupposed important other moral constraints without which markets could not operate efficiently over the long term. (See Amartya Sen, Capitalism Beyond the Crisis, N.Y. Rev. Books, March 26, 2009.)

So no matter where we stand on the ideological spectrum, with extreme exceptions, regulation is understood to be a complex activity without which markets cannot function properly. Quite apart from the maintenance of free and competitive markets, regulation is also used as the technique by which public safety standards are applied and enforced, to incent market activity considered socially desirable, and to apply other kinds of correctives that only collective, not individual, action can ensure (protecting the commons). There are many reasons why, even in a free market economy, we have extensive regulation. The trick is how to develop and maintain fair, democratic and effective regulation–and this of course presents much more of a difficult challenge than first meets the eye.